The federal and state governments,
including Vermont, have adopted various systems for taxing the transfer
of wealth. Under these systems, transfers which occur during
life (see the Lifetime Gifts webpage) and at death
are subject to taxation. The estate and gift transfer tax systems
are "unified," which means that gifts made during life can affect the amount
of tax due upon death (see The Federal Estate Tax System,
below).

Generally, the tax is imposed on
the value of assets transferred, less certain deductions and expenses,
and subject to certain credits. Like income taxes, the transfer taxes
are graduated, so that larger estates pay taxes at a higher overall rate
than smaller estates -- in fact, many smaller estates pay no transfer taxes
at all. Estate taxes are paid by the estate, and not the recipient.

The Federal
Estate Tax System

The federal estate tax system begins with the
concept of the "gross estate." Simply put, the gross estate consists
of all property, real or personal, tangible or intangible, wherever situated
in which the decedent had an interest at the time of his or her death.

Aside from the obvious property interests, the
gross estate includes the following:

(1) Life insurance
which the decedent owned, or had any incidences of ownership in;(2) Property in which the decedent
retained a life estate;(3) Certain transfers made
within three years of death;(4) Transfers effective at
death;(5) Annuities; (6) Pension assets (including
IRA's); and(7) Property over which the
decedent had a general power of appointment at the time of death.

Property included in the gross estate is valued at
the date of death (although an election may be available for an alternate
valuation date.

Once the gross estate is determined, certain deductions
are permitted. The most common deductions are for transfers to the
decedent's spouse (see Marital Deduction, below),
transfers to charity (see Charitable Deduction,
below), state estate taxes paid, the decedent's debts, funeral and burial expenses, and the expenses
of administering the estate (attorney and accountant fees, executor fees,
etc.). The gross estate minus these deductions is known as the "taxable
estate."

If the decedent made
taxable gifts during life, these gifts are added back to the
estate before calculating the tax (this is one way in which the estate and gift
transfer tax systems are unified). The estate tax is calculated on this total
amount, using a graduated tax schedule which for 2017 and beyond starts at a rate of 18% for estates
below $10,000, and quickly rises to a rate of 40% on estates in excess of
$1,000,000 (2017 rate table). The same tax rate
applies to gifts (another unifying feature of estate and gift taxation).

Once the estate tax is
calculated, certain credits are allowed. Each individual is allowed a
unified credit which can be applied to transfers made both during life and at
death (again, unification of the tax systems). In 2017, the unified credit
is $2,165,800 (which effectively means that estates of $5.49 million or less are
not subject to estate tax).

A key aspect of the
federal estate tax is that the unified credit is "portable." This means that a
husband and wife each have a credit of $5.49 million, for a total of $10.98 million. To the extent that the credit of one spouse is not used (at the first spouse's death), the survivor may use the unused credit to shelter his/her estate.

A
credit is allowed for foreign death taxes paid. Finally, a credit is allowed
for taxes paid on gifts which were added back to the estate before calculating
the estate tax (the last step in unification).

[MAY 1, 2017: The Trump
Administration has recommended a complete repeal of the federal estate tax as part
of reforming the federal tax system. Stayed tuned.]

The Vermont
Estate Tax System

Vermont recently
enacted new legislation that imposes a state estate tax regardless of whether
there is a federal estate tax imposed. Under this new system, for
Vermonters dying on or after January 1, 2016, estates in excess
of $2.75 million are subject to tax. The tax is assessed at a flat rate
of 16% of any estate valued over $2.75 million. Unlike the federal system,
only taxable gifts made within 2 years of the date of death are included in the
estate (and subject to tax).

Unlike the federal estate tax system, Vermont does not permit the portability of credits.

A Sample Federal Estate Tax Calculation

In order to illustrate the application of the
transfer tax systems discussed above, consider the following example:

John Smith, a widower and Vermont resident, dies on
March 1, 2016 owning assets valued on that date as follows:

House

$3,325,000

Vacation Home

$ 90,000

Stocks & Bonds

$ 1,680,000

Life Insurance

$ 500,000 (proceeds)

IRA

$ 450,000

Cash

$ 200,000

Personal property/boat

$ 80,000

Total estate

$6,325,000

The decedent had a mortgage of $55,000 on his
home, and credit card debt of $2,000. Funeral and burial costs were
$8,000. Attorney and accountant fees totaled $6,000. The executor
charged $2,000 to administer the estate. The decedent made no taxable
gifts during his lifetime.

From the gross estate, the debts of $57,000 (mortgage
& credit cards) are subtracted, as are all of the expenses of administering
the estate ($16,000), and the (sizeable) Vermont state death tax ($542,256) to arrive at a taxable estate of $5,709,744.
In 2017, the federal tentative tax on an estate of this size is $2,229,698 -- the estate is in the 40%
marginal estate tax bracket.Against this tax is allowed the unified credit
of $2,165,800 for a total (payable) federal estate tax of $63,898.

The Marital
Deduction - QTIPs

For a married person, a major estate tax benefit
is the ability to transfer assets to his or her spouse free of estate (or
gift) taxation. Any property transferred to a spouse, whether during
life or at death, is deductible from the gross estate prior to the calculation
of the estate tax. This deduction is often the principal focus of
estate plans involving married couples. Transfers may be made outright, or in a trust known as a
QTIP.

"QTIP" is an acronym for "qualified terminable
interest property." A QTIP is a special type of transfer from one
spouse to another that allows the transferring spouse to attach strings
to the transfer while still preserving the marital deduction. A transfer
will qualify as a QTIP if, at a minimum, the spouse receiving the
property receives all of the income from the property during his or her
life. This permits the transferring spouse to direct how the property
(the principal) will ultimately be disposed of. For example, a husband
can transfer property to his wife, and provide that she will receive the
income for her life, with the property passing to their children at the
wife's death -- this transfer will qualify for QTIP treatment, and the
marital deduction for estate tax purposes.

In most cases, a living trust is used to make
a QTIP transfer. In the above example, the trust could further authorize
the trustee to make distributions of principal to the wife, if needed.
The wife could also be given a limited (or unlimited) right to withdraw
principal. Therefore, a QTIP can be molded to fit almost any estate
planning need while maintaining the estate tax benefit of the marital deduction.

At the death of the surviving spouse, any QTIP
assets held for his or her benefit are included in the surviving spouse's
estate and subject to tax.

The
Charitable Deduction

Another method for reducing estate taxes is through
the use of a charitable deduction. The value of property which is
left to a charity through a decedent's Will, trust or otherwise, is deductible
from the decedent's gross estate. Gifts to charities can be outright,
or can be made by utilizing a charitable trust (see the Charitable
Trusts webpage).

Keep in mind that a deduction is allowed only
for gifts made to a "charity" -- a term which has a very specific meaning
under the Internal Revenue Code. Some organizations which are not-for-profit
may not qualify as a charity for estate tax purposes. You should
therefore check the status of any organization named in your estate plan
if the resulting charitable deduction is part of your planning. Similarly,
your estate plan should provide for one or more alternate charitable beneficiaries
in case your primary beneficiary ceases to exist or loses its status as
a charity.

Generation
Skipping Transfer Taxation

As if the taxes discussed above are not enough,
the federal system imposes yet another tax on transfers which "skip" a
generation. The theory of the generation skipping transfer tax (or
"GST") is that if (for example) a grandparent transfers assets to a grandchild
(known as a "skip person"), the estate tax that would have been
imposed on the middle generation (i.e. the grandparent's child) is lost.
To recoup this tax, the GST is imposed on any transfer (not necessarily
from grandparent to grandchild) which skips a generation. For 2017 and
beyond, the GST
is imposed at the highest marginal estate tax rate (40%), and is in addition
to the estate tax levied on the same transfer. Where both taxes apply,
the resulting tax can exceed 50%.

Some relief is afforded under the GST rules.
First, each individual is permitted to transfer up to $5.49 million to "skip"
persons without the imposition of the GST (2017). Therefore, the GST affects
only larger estates. Second, during life, an individual can gift
up to $14,000 per year/per skip person without incurring GST (see the
Lifetime
Gifts webpage).

To put it mildly, GST planning is very complicated.
There are many rules governing the use of trusts, the assignment of generational
levels, the application of the $5.49 million exemption, etc. which make the GST one of the most difficult areas of tax law.